Lorillard's Lack of Diversification Is a Concern Going Forward

Lorillard (NYSE: LO) is considered by many to be one of the US' better tobacco companies. Indeed, unlike the situation at peers Altria (NYSE: MO) and Reynolds American (NYSE: RAI) , the volume of cigarettes sold by Lorillard is still rising. Specifically, Lorillard's leading cigarette brand Newport reported a 0.5% increase in the number of cigarettes shipped during 2013, which does not seem like much at first. However, considering the fact that on average the tobacco industry reported a 6% decline in the number of cigarettes sold, it's an impressive metric.

However...Having said all of that, Lorillard is actually the least diversified of the three major domestic tobacco companies, and this is worrying. You see, while Lorillard's peers Reynolds American and Altria have many additional product lines aside from cigarettes, Lorillard's only diversification is into electronic cigarettes, or e-cigs. While Lorillard's exposure to the e-cig industry does offer some diversification, the company's e-cig sales are relatively non-existent in comparison to the rest of the business.

Before I go into Lorillard's lack of diversification, let's take a look at close peers Reynolds American and Altria. Firstly, let's look at industry behemoth Altria.

Peer diversification Altria has a 50% share of the US cigarette market, so the company is somewhat of a bellwether for the US' domestic tobacco market. However, Altria is already ahead of the curve as the company no longer relies upon cigarettes for its income. If we strip down Altria's full-year 2013 results, we get the following operating income breakdown.

As you can see from the table, although Altria gets three quarters of its income from smokeable products such as cigarettes and cigars, a quarter of the company's income comes from more sustainable sources. These sustainable sources include the company's holding in SABMiller, smokeless products, and wine sales. As of yet these figures do not include data from Altria's recently launched e-cig product.

Furthermore, as shown in the table below, Reynolds generates approximately 80% of its adjusted operating income from the sale of cigarettes. The remaining 20% comes from the sale of snuff and cigars.

Lorillard looks underprepared All in all, this leaves Lorillard looking under-diversified and ultimately underprepared for the eventual eradication of cigarettes.

As mentioned above, Lorillard does have its e-cig business as an alternative income stream to that from traditional cigarettes. Still, based on full-year 2013 results, operating income from e-cigs accounted for less than 1% of Lorillard's total operating income during the year.

What's more, we need to consider how Lorillard's earnings from e-cigs will be affected in the future. Specifically, we should consider the impact on Lorillard's e-cig sales produced by the entries of Reynolds American and Altria into the market. There is also the possibility of strict regulation of the e-cig market, which would obviously impact profits. With these factors in mind it's not unreasonable to assume that right now Lorillard's future, in diversification terms anyway, is uncertain and it looks as if the company needs to find some other revenue streams.

Foolish summary So all in all, although the volume of cigarettes sold by Lorillard is still rising, the company's lack of diversification is concerning. Indeed, while Lorillard is still outperforming in the cigarette market at present, it is unlikely that this will always be the case as cigarettes are widely thought to be in terminal decline. Taking this into account, the company with the most diversification would appear to be your best long-term bet, and right now that company is Altria.

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